Strengthening the euro area architecture through risk sharing and public backstops to prevent ‘bad equilibrium’: ECB’s Draghi (belatedly) finds common cause with the IMF on euro area reform

Ben Clift05 June 2018

Stephen Jaffe/IMF

Debate on euro area reform has been split between two camps: those who saw the euro area crisis as a consequence of moral hazard, and those who saw the threat of contagion effects through vulnerable financial markets. In this post, Ben Clift details how ECB Governor Mario Draghi’s recent speech proposing a full realisation of the banking union, with risk sharing and public backstops to prevent ‘bad equilibrium’, signals that the ECB’s vision for euro area reform has finally shifted to the latter, in line with the IMF’s vision for euro area architecture reform.

In a recent speech charting the evolution of the euro area architecture in and through the euro area crisis, ECB Governor Mario Draghi noted how the “crisis revealed some specific fragilities in the euro area’s construction”. Evoking a theme consistently foregrounded by the IMF, he noted how the Global Crisis and euro area crisis revealed “excessive optimism in the self-repairing power of markets”. Draghi proposed a full realisation of the banking union, which requires the European Bank Resolution Fund to have a public backstop. The rationale is straightforward: “Public risk-sharing through backstops helps reduce risks across the system by containing market panics when a crisis hits.” If the banking union were achieved on this basis, then the private sector, not the public, would bear the costs of future bank failures—generating valuable fiscal space for European governments.

As I detail in my new book, The IMF and the Politics of Austerity in the Wake of the Global Financial Crisis, it is a vision of public power, and public goods, which echoes how the IMF has been envisaging euro area architecture reform. Ever since the sovereign debt crisis erupted in 2010, the Fund has regularly set out this line and this logic, arguing that the ECB needs to act as lender of last resort for the euro area, and other backstops needed bolstering.The Fund’s reform agenda consistently called upon the ECB to embrace and expand its quantitative-easing-style monetary policy and government bond buying actions via first the Securities Market Programme and later Outright Monetary Transactions. At each stage when European authorities came together to seek crisis resolution measures, the Fund urged hesitant European policymakers and authorities to go further and faster to restore confidence, limit contagion, and strengthen backstops and countercyclical firepower.

Draghi’s agenda is also quite closely aligned with French preferences, and it recalls Hollande’s 2012 ambitions for the banking union, which were themselves built on IMF research initiatives. The Fund’s ambitions in this realm are long-standing and relatively consistent. Back in 2011, the IMF pushed for delivery on the ‘strong policy response’ agreed by European leaders at the 21 July European summit (IMF 2011). This had promised direct recapitalisation of banks using the nascent EU firewall initiatives – the European Financial Stability Facility (EFSF) and European Stability Mechanism (ESF) – and the buying of government bonds in the secondary market, acting on a precautionary basis. Meanwhile, the Fund urged the ECB to continue “to intervene strongly to maintain orderly conditions in sovereign debt markets” (code for bond-buying), and to reduce interest rates to tackle deflationary concerns (IMF 2011).

The ESF, the Fund argued, needed to be empowered to limit financial market contagion (IMF 2011). One of the central imperatives of resolving the European banking and sovereign debt crisis, IMF Managing Director Christine Lagarde noted to a Berlin audience in January 2012, was “larger firewalls”. Recently, the Fund has welcomed plans for a European Monetary Fund for similar crisis-prevention firepower reasons.

Up to now, a major impediment to the realisation of this agenda has been resistance and lack of buy-in from key European players including the German government and – previously – the ECB. Draghi’s recent speech counter-posed “those who saw the crisis as a consequence of moral hazard”, who emphasise solutions which entail “a return of market discipline”, with those who saw the real threats as contagion effects through vulnerable financial markets. The IMF, France, and– now it seems– Draghi at the ECB, fall in the latter camp. Earlier in the Eurozone Crisis, fiscal hawks at the ECB, Wolfgang Schäuble, Angela Merkel, and in the Dutch, Austrian and Finnish governments fell into the former camp.

In the period before Draghi’s July 2012 ‘whatever it takes’ intervention, which calmed markets and reduced European sovereign borrowing costs, those focused on moral hazard and market discipline did not want to let the crisis go to waste. They saw the market pressure, which underdeveloped firewalls prolonged, as a necessary spur to competitiveness-enhancing reforms and fiscal discipline. Dissipating bond market pressure ran the risk of letting under-reforming governments, who might be soft-pedalling on fiscal adjustment and labour market reform, off the hook. This logic undermined EU-wide efforts to put in place effective measures muscular enough to limit financial market contagion of the kinds Draghi today advocates.

In Draghi’s view, vulnerabilities of financial markets saw increased sovereign risk in countries such as Greece, Italy, and Portugal transmitted into domestic banking sectors, firstly through banks’ increased exposures to weakening sovereign bond rates, which ate away at confidence in the solvency of national banking systems. This was compounded by a severe loss of confidence across the real and financial sectors. This account echoes the IMF’s overall take on the crisis. In setting out its implications, Draghi directly reprises IMF language: “governments in these countries found themselves unable to substantially respond to the emerging crisis with public money for the banking sector and countercyclical fiscal policy, due to lack of fiscal space”.

Again evoking language beloved of the post-crash Fund, Draghi argues that this trapped Europe in a ‘bad equilibrium’ and a ‘downward growth spiral’. What was required, in a classic New Keynesian manoeuvre, was for public power to intervene decisively. Addressing confidence issues through growth-oriented fiscal policy, unconventional monetary policy, and other measures were key to moving Europe’s economic and financial system slowly towards a ‘good equilibrium’. This, as my book points out, is what persistent IMF calls for powerful backstops and firewalls, and strengthening the counter-cyclical capacity of the ESM, have been all about ever since 2010-11.

Individual countries and financial sectors could not, the euro area crisis had proved, absorb the shocks visited upon them. A European-level shock absorber had to do the trick, since this could enable national fiscal policy to act as a more effective stabiliser. The solution? Draghi calls for greater “private risk-sharing in the Eurozone”, which “has to be enabled by public sector policies at both the national and union levels.”

Completing the banking union, including accomplishing the still-underdeveloped European deposit insurance, is crucial to this. Yet in claiming that “the new EU resolution framework has shifted the cost of bank failures away from sovereigns and onto the financial sector”, Draghi presents a rather rose-tinted view of how far the banking union has achieved the initial objectives set out by the IMF and Francois Hollande all those years ago. It remains to be seen how far the ECB’s apparent rallying to this cause can overcome the remaining impediments to its realisation.